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I had originally thought that I could cover this topic in a long single blog post. I think that does a disservice to the complexity of the subject matter. Accordingly, I hope to paint the broad brush strokes here and then get to the specifics of each business line in the Tesla portfolio.

I tweeted earlier that I want this information to be accessible to non-financial readers but, also, have enough in it to be informative for financial pros. I fear that the objectives of the former will make it too superficial for the latter. But, I’ll (pun intended) charge on.

Overview

The conventional wisdom tends to look at Tesla as having two business lines: auto manufacturing and, with its acquisition of Solar City, solar power. I think that doesn’t allow the market to see either the co-dependence or the separate opportunities and risks in the sectors in which they operate.

I see their major business lines as thus:

Auto Manufacturing

Truck Manufacturing

Auto retailing

Power storage

Power distribution

Autonomous driving technology

I imagine that many will look at this list of being somewhat pedantic in it’s definitions but, zooming out, each one of these business lines can stand on their own and allows us to put their activities in a comparative framework within specific industries. Additionally, each one of these lines could (and some perhaps will) be converted out of their proprietary use and, if push comes to shove, be sold or marketed to the non-Tesla public.

With that in mind let’s look at the big picture of each of those lines starting with Autos.

Auto Manufacturing – State of the Industry

To put Tesla’s auto manufacturing business in context here’s what the world looks like today.

Global fleet of passenger vehicles and transpiration trucks in service = 1.2 biillion

Total number of BEVs and HEVs sold in the world to date = 3 million which is slightly less than 2% of the worldwide vehicle fleet..

2017 market share of EVs to all transportation vehicles = 1%

If Tesla meets it’s goals of selling 600K cars by 2020 it will produce roughly 1,600 cars per day. Today, GM and Toyota produce about 28K cars per day each.

Here are the latest numbers on total US EV sales of both pure EV and hybrid for 2017. With the final numbers to be reported soon it looks like the total plug-in EV market will be around 200K autos in the U.S. wihich is about 1.2% of the total U.S. market.

A Crush of EV Competition Is Happening Now

Auto manufacturers have announced plans to bring to market no less than 100 new EV models in the next five years. It remains to be seen if the actual end demand justifies such an industry wide investment. So far, car buyers seem quite happy with internal combustion engines – both for price and convenience.

EVs v Internal Combustion

Currently, an EV drive train runs about $10K more for a 200+ mile range than a gas powered car getting 400 miles on a fill up. Old school auto industry reporters don’t see the US EV market really gaining traction at the rate EV enthusiast see simply for the inconvenience factor of charging and the monthly payment difference. I suspect that the internal combustion engine will be with us for quite some time – at least until the cost differential sinks and the problem of charge times gets solved.

Also, given the low energy density of batteries it looks like a while until consumer preferences for full-sized and SUVs and light trucks -currently above 50% of the total U.S. market- can become cost competitive and practical (here is where fuel cell technology, if improved, would pay big benefits.)

Meanwhile, many plug-in hybrids (HEVs) offer nearly the same green footprint for the average driver by offering the benefit of all electric travel for 95% of their driving and avoids the inconvenience of charging wait times when hauling the family to Mount Rushmore for the summer vacation.

For example, the Toyota Prius Prime boasts a 640 mile range with an estimated 133 MPGe and a reasonable 54 combined MPG for long road trips. Although it only has a range of 25 miles of pure electric driving that’s good enough for most to commute to work and run daily errands. With tax credits, the price nets out at about $25K with the mid-level trim package compared to roughly $35K for the Chevy Bolt and (the yet to be built) 220 mile range Tesla Model 3. Most manufacturers have HEVs in this swatch of the market in their 2018 line-up.

Pure Electric

On the pure EV front, the space is somewhat less competitive for 2018 but 2019 promises vast choices beyond GM and Tesla. However, a big contender in 2018 will be the new Nissan Leaf with a 150 mile range for about $30K and the promise of a 200 mile range battery pack before the end of the year.

Tesla needs to be worried about competition for their Models S and X. Porsche and Jaguar will both deliver high-preformance EVs near the price point of the Model S in 2018. At a minimum, this will take some of the starch out Tesla’s proprietary “sexy factor.” There’s a lot more coming into the space by 2020 from the likes of BMW, Mercedes-Benze, etc.

Going into the next decade there is huge commitment to EV production across all manufacturers. GM promises 20 pure EV models by 2023 and VW has committed $32 Billion to EVs over the next decade. Again, we’ll see where market acceptance leads to sales but, if EVs fail to really become mainstream in the next 5 years, at least everyone is going down together. This points to the obvious benefit of being a legacy manufacturer that can sell internal combustion engines while they size real demand for EVs.

The Short of It

It’s true that Tesla has some competitive advantages currently with a combination of marketing hype, mobile charging stations, and sex appeal. I’ll get to those in later installments as well as the technology risks that Tesla suffers by a rapid expansion in production goals.

Leave it to say, however, that this might prove to be ephemeral over the next ten years. The competition is heating up by companies who really know how to make cars, understand end demand, and are extremely well capitalized – none of which Tesla has demonstrated well (what happens when the Model 3 deposit holders get all the deliveries they want and the number of competing products increases dramatically?)

A lot of people have offered up the analog that Tesla cars are the new iPhone. I reject that summarily – which I plan to write about. But if I was to use that type of analogy, I’d use Blackberry. As in most industries, it’s the second mouse that gets the cheese.

That’s the view from 10,000 ft. I’ll get much more specific as we go.

Next Up: The Tesla Semi – wherein I’ll debunk the breathless fawning of fanboys who think it’s a game-changer and show how Tesla is, if fact, behind the curve.

ps: There’s a ton to cover in doing a thorough analysis. I’ll get to financials, production overhead, scale economies and a host of other matters. Still, I think if I give you a 20,000 word piece you’ll stop reading. Ergo, I’m breaking it into bite-sized bits.

There is no disputing that Elon Musk is a visionary and there is also no disputing that bringing a new car technology to market is something that very few have accomplished. In fact, the last durable entry in the U.S was Chrysler Motors in 1922. Credit where due.

Musk is on a mission to save mankind from itself and it can’t go unnoticed that he’s sees the possibility of a Malthusian world which can only be salvaged with a Julian Simon solution. It’s big, bold and beautiful.

Still, that vision has some distance to go to become reality and the representations that Musk makes – about both the future and his proposed products – require a leap of faith in the evolution of technology.

Tyler Cowen thinks that Musk might be “bootstrapping” his vision of the future to today’s reality. Think of that like the golfer who makes his game by “envisioning where the ball will go” before swinging his club. It’s Zen. It’s Steve Jobs. There’s something to be said for that and, I rather imagine, nothing truly great happens without that ability.

Thus, I suggest that Elon has the potential for greatness. I will also suggest he already sees himself as great and, as often happens, that could be his undoing.

Innovation v Management Skills

There’s a wonderful combination of skill sets in Musk; part inventor, part innovator, part idea thief, and not the least, part evangelical preacher. Still, if we look at his big ideas – EVs for the masses, reusable rockets, the Hyperloop and it’s per-requisite technology earth boring – how can one argue he’s not, at a minimum, a marvelous innovator.

Often, however, being an innovative genius doesn’t come with the requisite skill set to take good ideas and turn them into great businesses. Since the Tesla Model 3 is often mentioned as “the next iPhone” (which I’ll address later) let’s use Steve Jobs as a analog.

Yes, Kemosabe

Jobs, as we recall, was fired from Apple in 1985. He was ousted after the disappointing launch of the Mac but primarily because he was an overbearing boss who treated his team poorly and expected too much from them. This was his greatest business lesson.

Of course Jobs made it back to Apple in 1996 and became CEO 1997. Apple continued to limp along but in 1998 Jobs met Tim Cook and hired him as SVP of World Operations.

When Apple launched its next truly innovative product in 2001, the iPod, it was Cook who sourced the supply chain helping to decide what components and assembly processes should be outsourced. Jobs was the vision and Cook made it happen. And that happened again with the iPhone, and the iPad. The rest, as we say, is history.The question is, then, does Elon Musk get a Tim Cook and, if he does, will he let him operate?

Management Structure

Unlike most management structures, Tesla’s is unusually horizontal and it’s very difficult to tell what real hierarchies exist.

This seems especially odd to me from the vantage point of investor relations. Most public companies have long lists with accompanying bios of their top talent to showcase the depth of management.

Going outside of company information there is a little more information about executive personnel but no information on chain-of-command that I could find. What’s striking to me is little we know about auto industry experience in the ranks. For example, in the above link I could only find one executive, Gilbert Passin, with auto manufacturing experience.

There is also a dearth of executive hiring announcements over time. In May of 2016 there was a lot of fanfare in the hiring of former VW executive Peter Hochholdinger as its vice president of vehicle production. This looks to me like a great hire but since coming on board he has been fairly invisible to the public.

It is quite noticeable (at least to me) the lack of manufacturing engineers that can be identified in public documents. I see a lot of electrical engineers – which makes sense form a design standpoint. From my perspective, I see a lack of talent of people who know how to build machines to that build machines. Maybe they’re there. There’s no way to know.

And there also seems to be a lack of substantial product managers who organize each business line in a single portfolio. for example I find one executive for supply chain management instead of one for each business line. Again, who knows?

Turbulence at the Top of House

There has been a somewhat alarming list of executives that have left Tesla in the last 18 months – in the wake of the Model 3 announcement. Most of the departees have had little to say publically about either working for Tesla or their reasons for leaving. Below is a list of talent that decided to look for greener pastures:

Musk is famous for sleeping in his various manufacturing plants as well. One could argue that this demonstrates how vested he is in his company’s success. One could argue as well that it’s a sign of micro-management that impedes his executives from growing and delivers a superfluous amount of second guessing that staunches manager’s personal sense of organizational agency.

The best I can glean from all of this is that Elon Musk requires that he control nearly every decision and has yet to learn how to let his people either succeed or fail on their own. As the company grows this will be increasing problem if he doesn’t change.

Maybe he gets past this. Maybe he finds his Tim Cook to act as his COO and he then chills out. But my take-away is that he doesn’t trust his hires to do what he hired them to. Think about the non-disparagement clauses he insists separated employees sign before getting severance.

In the Part 2 of this series I will break down Tesla’s business lines, the competitive backdrop of each. I’ll also look at resource allocation between business lines. There’s a lot more to come after that.

There are a lot of people in my life, both friends and strangers, to whom I will never be able to repay their generosity. As nearly as impossible as it is, I try to count every one of the gifts I receive, large and small, and recognize that the individuals who gave them make up the tapestry of my fortunes – material or otherwise.

So, as small as this offer to the the karmic spirits is, I’m on a mission from God to teach young people the basics of personal finance. After all, it’s the least I can do – especially since my generation looks as if we intend to bleed the kids white by our failure to address entitlement reform. But I’ll leave the political/economic malfeasance of us Boomers to separate rant.

I have to choose a medium outside of this blog to get to this task and I’ll find a good interim solution somewhere I’m sure. I’ll let it evolve and see where it leads. But these are some of the fundamental areas I’d like to include (in no particular order.):

Basics of Budgeting

Long Term Financial Planning

The Time Value of Money

Saving Strategies

Intro to Investment Strategies

Insurance

Other topics are sure to come along and, obviously, each of the above has sub-topics.

[Note: My sardonic imagination conjures up irreverent articles like “So, you pissed away half of your inheritance. What next?” and other sundry (mis)acts of life. (or, maybe not). It’s one of my shortcomings.]

I know, there are guys like Dave Ramsey who are all over this and, frankly, I plan to borrow heavily from him. The problem is, Ramsey has some tools of which the sexy ones he wants to charge you for. Good for him, but there are a lot of free services (like Mint.com) that do just as well. He also doesn’t get very deep into the conceptual framework at the basic level. You know, things like teaching people what it means to their retirement if they skip eating out once a week.

What we won’t cover are things like economics and trading. The target audience isn’t suited for trading (most people aren’t suited for trading) but need to start investing and economics is the surest way to chase people off. The real need is to get people to start thinking in simple personal finance terms.

I know that for many of you all of this is so basic that you may think the whole effort is entirely “ignorable.” But having been in financial services for almost four decades, I can tell how much need there is for this. I’ve seen it all my professional life. I can also tell you that no one will pay attention if it’s not fun, contemporary, and builds a community.

My father told me at a young age “If you’re going to make money in finance, you need to work for people who have some.” Well, that’s is not this target audience. I’m not in this for the money.

But I’m gunna need some help. Maybe you’re interested either out of the goodness of your heart or to use as a tool for other financial advice you give.

First and foremost, I really need someone who can write a really simple mobile app, hopefully for both IOS and Android, about time value of money that looks something like this. I’d like to figure out how to turn it into a game eventually and see if a community can be built around it. Anyone who writes it can own it but you have to give me/us permission to use it.

Secondly, there’s all sorts of things that I’m not as proficient at as others such as insurance analysis and long term financial planning. And of course, when it comes to investment strategies, I have mine but I’m no expert at many others.

We’ll work on the details together and build a strategy as it moves forward. No one involved will be expected to stay involved if they don’t want to. And, obviously, I won’t ask anyone for any money. I’ll pay for the web resources required and other miscellaneous stuff.

If you’re interested in getting involved – and I’ll leave your motivations to you without question – leave me a comment as to what you’re interested in. Make sure you put a good email address in the comment for (no one but me can see it). I have to approve your first comment before it shows up so don’t think your comment has gone into the bit bucket. It just might take me a day to get to it.

Anyhow, I’ll do this alone if I have to but I have a suspicion that I’m not alone in seeing the need for this – if only for wayward relatives.

I had a great conversation with my dad last night that I though was worth sharing.

In the late 1990s my father and a couple of other acccounting PhDs published an academic paper in Accounting Horizons of a study of which the null hypothesis was:

Over the long term the cash flow of a company should equal its net income.

They went back 30 years using Compustat data and reconstructed GAAP cash flow [Note, GAAP cash flow is a fairly recent convention and was not used at the time of beginning of the study.)

Their conclusion was very interesting insofar as the null hypothesis was proven to be not true.

Their finding were.

GAAP cash flow reported tended to be highly overstated because (in order of impact):

Periodic adjustments and reclassifications to fixed assets and associated depreciation were substantial over time.

Amortization of goodwill was random to the point of meanlessness.

The inclusion of working capital in cash flow was erroneous to the extent that current assets both have dynamic valuations (as in inventory) and often was a contract-indecator to the viability of the operation.

The last point was most interesting to me since I’ve been around long enough to see outsized adjustments to the other two.

Dad was quick to point out that cash flow under GAAP was improved if a company just decided to slow down payment to trade creditors – hardly an indicator of good working capital management.

The article made quite a splash in academic circles and the community pressed the FASB to reconsider GAAP cash flow reporting – which they never have brought up for review.

In summary he thinks GAAP cash flow reporting is highly flawed and, on any one reporting period, is very unreliable as a measure valuation.

Where “A” is some esoteric metric far from the main in technical analysis.

These observations are an attempt to be constructive either by demonstrating a correlation or a lack thereof. I can’t say with any certainty that any of those correlations are wrong. But neither can most of these people prove they’re predictive.

For the most part, though, I see this stuff as an effort at legitimate quantitative analysis. I’m sure the people doing this work think they are. It’s not and, in fact, it’s usually just a terribly bad misuse of statistics.

Absent in most of these data sets is any substantive regression analysis, confidence intervals or even a mention of a standard deviation. You know, the stuff taught in Intro to Statistics classes.

The larger error in my opinion is that quantitative analysis most often demands multivariate correlations for predictions in complex systems.

I double-dog dare you to argue that the capital markets are not complex systems.

Missing are things like time-varying covariates, correlation to an alternate principal component, and confounding and/or interacting variables – just to name a few.

Don’t get me wrong. There are some simple models that show higher correlations to future market movements. Most of these are well known such as extremes in the put/call ratio or tested indicators like the McClellan Oscillator. For the most part, though, they’re only predictive of short term moves and all of them fail from time to time.

Good quant is very hard. Why do you think Wall Street hires physicists, mathematicians and engineers? I’m pretty sure it’s not from their prowess in single variable regression analysis.

The really smart people would even dismiss the multivariate regression approach and use Chaos Theory. They tell us that the market is too dynamic for anything but “chaos” to prevail and forecasting needs to be approached by models used in quantum physics. Really heady stuff.

Chaos: When the present determines the future, but the approximate present does not approximately determine the future.

Think of this graphic when looking at how co-dependent variables interact and the randomness it generates. Now, complicate that with a hundred variables. (h/t Wikipedia.)

When a butterfly flaps its wings…

For the record, I have a bare minimum familiarity with Chaos Theory. I do have, however, significant training in statistically based quantitative analysis. And the only certainty one gets from post graduate study of QA is how error prone – or perhaps I should say “imprecise” – it is; as in “There is an X% probability of Y happening with a Z% confidence interval. Or, as Nate Silver might explain “Why polls fail.”

That said, it’s much better to have some model especially if you’re watching for when it fails.

But having a single variable correlation model might be worse than having nothing.

There, I said it. You can all commence with telling me how I’m wrong. But I’m not. Unfollow me. Vote me off the island. Throw me out of the band. Whatever.

I just calls it as I sees it. And I call most of this worthless. It’s just throwing chicken bones.

—–

What Value Is Studying Economics?

Every time I read an econometric model (more often than I care to admit) I start out with “assume a can opener.” and head to the conclusion.

Let’s start with the fact that I am not now nor ever have been an economist (imagine my serious voice.) Let me also say that I have been seriously studying economic theory most of my adult life and have, for perhaps 30 years, spent on average an hour a day reading economic research and academic papers. I have found that there are very few subjects at the Masters degree level that I’m unfamiliar in macro economics. The outcome has been: the more I learn the less I know. So why do I do it?

1 – Simplification. Thinking like an economist helps me reduce complex problems into manageable models. We can see correlations much better if we properly isolate variables. It helps us build a context for how we imagine how things work and gives us a baseline from which to test our understanding.

2 – Beauty. I came to the conclusion at a young age that I would never be a giant thinker. I have, though, always been in awe of minds that have countered and changed popular conventions (my older brother was force feeding me Bertrand Russell when I was 12.) The elegance of thought from history’s great economists, as with the great philosophers and writers, is just simply beautiful.

3 – Dear Old Dad. My father has minors in economics at the Bachelors, Masters and Doctorate levels. While I was in college he constantly poked at my economic and financial thinking with a continuous (and most annoying) Socratic dialogue. I’m sure that he enjoyed having at least one of his three sons who aspired to beat him in a debate. He played my ego and that caused me to learn – and then caused me to question what I thought I had learned. He still does it and is the most effective devil’s advocate I’ve ever known. I use him to bounce investment theses off regularly. It is one of the few intellectual fortunes I have in my life. And he gave me a life-long curiosity for economics. Maybe it’s become a character flaw. It’s too soon to tell.

Buy the way, if you’re in the investment arena, nothing will serve you better than an honest and qualified devil’s advocate. If you don’t have one, find one – or ten. This is Ray Dalio’s approach.

What Economics Can’t Do

1 – Predict the near term capital markets. Although the markets respond to economic data they are, in fact, looking backward. Sure, certain data reinforces assumptions about longer term trends but those movements are reactive instead of predictive. I’ll get to the problems with economic data later.

What economic data primarily does to the markets is reinforce or upset sentiment. Some people can trade on that. I can’t. But investing on a single data point is just slightly less than completely insane as far as I’m concerned. If you’re a trend follower, apply that discipline to economic data. Understand too the glacial speed of economic trend changes outside of demand/supply shocks.

2 – Predict the economy. All we have to do is look at the best economists from the worlds central banks to prove this. The old joke among economists is “I’ve predicted 9 of the last 4 recessions.”

3 – Be correct. It can come close but it usually doesn’t. That is to say, like business forecasts, there is always a level of error.

Economics: It’s the data, stupid

Almost all government economic data is a statistical estimate. Real-time data can be exceptionally noisy. One standard deviation for the Non-farm Payroll report is roughly +/- 100,000 jobs. What does a beat or a miss of 50,000 jobs mean? Statistically nothing.

GDP estimates are a much more difficult task. The inputs for the GDP estimates are based on a set a surveys called the National Income and Product Accounts (NIPA.) The Bureau of Economic Analysis (BEA) understands the statistical error potential in their estimates. Observers are familiar with “advance”, “preliminary, and final quarterly GDP reports. But the BEA, being the home of world class statisticians, also does this:

Each quarterly estimate is subject to three successive annual revisions … The first annual revision incorporates further revisions in the monthly or quarterly source data and introduces some annual source data. The second and third annual revisions incorporate a broad range of annual source data. Each quarterly estimate is also subject to one or more comprehensive revisions, in which information from the economic and demographic censuses is incorporated.

In other words, we don’t have even the best guess until three years after the “final” quarterly report is delivered.

I don’t want to overstate the problem. It’s actually remarkable they do as well as they do. Nonetheless, it’s still statistics. So let’s revisit this:

Chaos: When the present determines the future, but the approximate present does not approximately determine the future.

We, and most of the developed economies, have reasonably well developed statistical processes. Thus, from a broad brush perspective, they are generally “directionally correct.” That said, they’re not very good at predicting trend changes. Most recessions are already in process by the time they are identified.

For the developing world the data is harder. China, India and Indonesia, for example, still have very underdeveloped and crude measuring processes. Consequently, all economic data from any of those countries is much more suspect than that of the developed world.

Human nature, of course, usually doesn’t lend itself to considering quality constructs of the data outside from where we live. This is the “hometown bias” in data interpretation. Ergo, there is a tendency to project the quality of one’s domestic data onto foreign data. That is a rather big mistake. Keep that in mind.

How I Use Economics In Investing

I think it’s important to stay on top of economic data as part of one’s investing discipline. But I think it equally important to understand its limitations. We get fooled by complex analysis thinking that complexity adds understanding. But I have to think that F.A Hayek was right that complex econometric models usually are just a pretense of knowledge. He referred to that as “Scientism“. The balance between over simplification (from above) and over-complexity is very hard to attain.

I had a finance professor who said “It’s an unfortunate fact that balance sheet balance because it can sometimes add a sense of legitimacy where none exists.” Economic models are much worse.

To be frank, I don’t rely on macro day to day but keep it in mind as a backdrop in my investment decisions. That said, when I use it I often get it wrong. I was convinced at the end of 2013 that industrial commodities had bottomed. Guess how that worked out.

But there are some things that it can be quite useful for given a long enough time horizon. For example, demographic trends will determine things like housing demand, generation specific goods and services consumption trend, etc.

The advice I would give to young investors is to focus on micro. It’s not the sexy stuff of which macro is made but it’s where your knowledge will actually give you an edge. You wanna look smart or do you wanna make money?

—–

Chicken Bones

A lot of what we do in developing investing theses really are no better than a Zulu fortune teller casting chicken bones. That shouldn’t stop us from trying to see the future but we should understand that what we think we know may be imaginary. To paraphrase Socrates, wisdom is the understanding of our own ignorance.

That’s why in investing it makes sense to have the default position to be “I could be wrong”. That’s why keeping and eye on and managing to the risk of a permanent loss of capital is every bit as important as seeking opportunities. Some would say more so.

Housekeeping

I’ve decided I will no longer share my trades on social media. There’s a handful of reasons:

Keep in mind, though, no matter what you do, what process you have, what data you think is valuable, I really am pulling for you. As we all know, this business is hard and all of us make mistakes.

Trade ’em well.

ps – comments are open and always welcome but due to the high level of spam I screen all commenters. Once I have approve your first comment all future comments will be approved by default. So if you comment give me a little while to see it an approve you. I get to it sooner or later.

I know it’s impolitic to pigeonhole people but I’m starting to see some clusters of Financial Twitter personality types that tempt me reach for the hemlock. So, in no particular order, here is what I have so far:

@SuperAlphaShvantz

This group comes with handles that imply an unusually sized trading meat stick endowment. It’s a special club with names like @MonsterAlphahedge, @BetaPlayah, etc. We’re informed they’ve already made every mistakes a trader could make. With those lessons learned, they are now immune to both significant losses – also gravity. And for a fee you too can become a billionaire. But if it doesn’t work out, well, you’re on your own. A strict no refund policy is observed.

@MrGravitas

I imagine, in real life, that if you compare these people to boiled turnips the turnips would be more fun. It’s not that they don’t occasionally have any useful market insights but mostly they spend their time picking the fly shit out of the data pepper. Every obscure and esoteric data set they present comes with a tone so serious that, if you don’t pay attention, the market might harvest your genitals.

@BullshitPlunger

This is a special group of genius that calls bullshit on every market prediction from every living market legend. The binary response is either A) they’re wrong or B) they’re made in bad faith to move the market. Everyone is suspect. There are no good faith arguments.

@MoodAffiliate

If confirmation bias could make you rich these types would rule the friggin’ world. It would be one thing if they ever laid out their own case but these guys simply find a narrative that supports their position and then try to beat you to death with it. If that’s not bad enough, the shear volume of bias confirming re-tweets shows up in your stream like the effluent in a broken public bus station toilet.

—

Be it far from me to curate anyone’s follow list. Personally, I’m working on reducing my Twitter consumption. I have found that both my mood and my productivity are much better off by ignoring most of it. Few people have a similar investing discipline as mine and the short-term traders do little but interject emotion into attitude.

I suppose the mountain of “if A happens then B – but we won’t know for a few days” tweets are good for people who can hop in and out of the market. I can’t do that with my clients’ accounts. I have many position (probably too many) to let the proclivities of a few days market action disrupt my theses for each holding.

So, I’ve come to the conclusion that too much Twitter is the psychological equivalent of intentionally laying down in a swarm of biting chiggers. It’s not enough to kill you but more than enough to distract you from making rational decisions.

Most of Finance Twitter, certainly not all, measure their success trade by trade. Those who manage other peoples’ money have only one standard – total return on assets under management. And we have only one group to answer to – our clients. It’s a game of basis points and alpha comes from positioning much more than trading.

Market View

As much as everyone cheered the market rally, I still think the market is expensive. Macro data is soft in the U.S and weak almost everywhere else. That’s not to say that the market is the economy – as proven by Friday’s tape.

My views are much the same as Tim Melvin’s who wrote last week in his news letter.

There simply are not enough cheap stocks to justify a full on commitment to the stock market.

That has lasted for a few years.

To me this market feels much more like 1987 that any other period. That’s in no way predicting a crash. It’s more the level of M&A and the premium being paid for deals. That year, however, left a deep psychological scar on me. It’s probably wise to understand my thinking that it could happen again makes me a very conservative investor. I suspect it always will

So I wait. Try to manage risk in the meantime. And work hard to try to disprove the theses I have on each of my positions.

Economic friction is everything that keeps markets from working according to the textbook model of perfect competition: Distance. Cost. Restrictive regulations. Imperfect information. In high-friction markets, customers don’t have many suppliers to choose among. Owning a factory — or a store with a good location — counts for a lot. It’s hard for new competitors to get into the game. The marketplace moves slowly and predictably. Low-friction markets are just the reverse. New competitors crop up all over, and customers are quick to respond. The marketplace is anything but predictable.

Economic orthodoxy regards a reduction in economic friction as an increase in efficiency – usually a good thing – and, by the work of economists such as Vilfredo Pareto (1848 – 1923) we come to the idea of a Pareto Optimality wherein:

Pareto efficiency, or Pareto optimality, is a state of allocation of resources in which it is impossible to make any one individual better off without making at least one individual worse off.

Pareto optimalities are, however, rare in the real world (the capital markets may be the exception) and most economists would agree that Pareto’s biggest contribution was the construct of the “Pareto Gain” where a marginal movement toward an optimality creates net gains for market participants. We know it as a “win-win”.

Pareto, though, was also a sociologist and did not claim that a market in an optimal state added to the well-being of society in every case. We’ll leave Pareto’s controversial social writing for another discussion.

Shut Up And Take My Money

I think about such things and, God knows, it’s a waste of time – but, as Russ Roberts might say, a lovely waste of time. In today’s economy, though, perhaps keeping friction factors, efficiency and, ultimately, productivity in mind we can better our lot in life.

Recently a Jimmy Johns was opened close to my house. I had never ordered from them prior to then. I installed their app, ordered a sandwich and, as advertised, it was delivered “freakishly fast.” Their app stores my order history and now I can compete the entire sales cycle from order to delivery in roughly 10 minutes. I’ve done it many times now.

Amazon differentiated itself when it introduced “1 click” purchasing. In doing so it removed about some 4 steps in placing an order from the traditional eCommerce site.

Domino’s Pizza has given us the ability to simply text a pizza emoji and your favorite pizza (I have significant trouble calling it “pizza” but, whatever) will come hot and fast to your home.

Twitter is working on a 1 click order system for nested ads that pop up in one’s stream.

I can go on and on. The number of these kind of apps are almost too numerous to count.

In economic terms, all this technology does represent significant reduction of friction and increase in efficiencies: Efficiently Separating People From Their Money For Impulse Purchases.

Is it a Pareto gain? At the risk of sounding like a “get off my lawn” Luddite, I’m thinking not.

Young adults, with a mountain of student loans and the crush of having to reconcile the future with a public Keynesian legacy in the trillion$, would be well served by more, rather than less, friction of this sort.

Meanwhile, most people – and millennials in particular – think it’s really cool. It is – until one overlays the time value of money on it.

As investors we like all of this. It’s fuel for sales. And Wall Street has a raft of new “stories” that tell us things like a coffee vendor is now really a technology play. Now that’s a win-win – especially for the sell side.

As a side note, I read this week that in 1950 the average household prepared 90% of their food. Today that has dropped to 50%. If you bemoan that we’re becoming an economy of people selling each other burgers, we’re on that trend.

Pareto Babies And Bath Water

Since near the middle of the recent bull run, the outcry for passive management (there really is no such thing) and ETF investing has increased in volume to the point that, near the end of 2014, paying management fees placed you in a very special class of boob – at least from the perspective of many economists and most financial journalists.

I know that one year does not a trend make but if you’re a 60/40 (70/30) portfolio “allocator”, you’ve been outperformed by cash YTD. I won’t go on again with the faults I see in Modern Portfolio Theory. I will say that many late comers that put their money in an MPT strategy won’t have the discipline to stay in. We see this every time the market plateaus or goes into a bear trend.

Like buying through Amazon, retail traders, 25 year old portfolio managers, and asset gathering investment advisors can buy a large swath of the market with one click through ETFs. It’s an efficiency we didn’t know in days of yore. On the other hand, the market structure tilt from so much money undermines price discovery of individual stocks. Just look what happened to biotechs last week if you need proof.

Now, from the standpoint of the health and the pricing component of efficient capital markets, I disagree with most economists that ETFs are in any way efficient other than reducing buyer friction. Because I love markets I don’t like what ETFs do to them.

As a money manager, however, one cannot help but embrace the price inefficiencies caused by the influence of ETFs on the market’s structure. That, though, is a two edged sword in the short run and riding the volatility can rattle one’s nerves. But alpha gets built on price inefficiency.

No matter if you’re a value or growth investor, this is where the gold is. Keep your watch lists current and set your alerts. Then wait for your price.

How I Did This Week

The portfolio was up about 30 bps and has been more or less flat for the last 3 week. The grind is hard. I have a feeling it’s going to stay tough for a while.

So many people are looking for a year end rally. I have no idea. The market tends to move on the path of greatest frustration. All we can do is watch.

Just to be clear, Fil was not commenting on Fed policy but, rather, the inconsistency of the prattle of the Fed Chair’s response during the Q&A session. It was confusing. The reaction from the market – at least for now – seems to confirm that. It shouldn’t escape anyone that the last two Fed decisions have not inspired the equity markets to rally. The salve that worked for the past many years looks now to be creating a rash of uncertainty. It reminds me of the words of Richard J. Daley during the 1968 Democratic National Convention riots.

The Police are not here to create disorder, they’re here to preserve disorder.

But maybe it’s much more simple than that. Maybe the Fed’s concern over international macro simply reminded the world that central banks, armed with fancy econometric models and past ideas of what creates moderate inflation, economic stability and growth, don’t or, perhaps, can’t work. I’ve proffered for several years that when confidence in central bank policy begins to fail – as they have from time to time through history – the risk premium in equities will increase (e.g lower prices for those unfamiliar.) I’m not sure we’re there yet. I do think we’re heading there. That said, I’d be a fool if I run with that thought with any certainty.

After all, pre-crisis, inflation was stable and traditional estimates of potential output proved, in retrospect, far too optimistic. If one acknowledges that low interest rates contributed to the financial boom whose collapse caused the crisis, and that, as the evidence indicates, both the boom and the subsequent crisis caused long-lasting damage to output, employment and productivity growth, it is hard to argue that rates were at their equilibrium level. This also means that interest rates are low today, at least in part, because they were too low in the past. Low rates beget still lower rates. In this sense, low rates are self-validating. Given signs of the build-up of financial imbalances in several parts of the world, there is a troubling element of déjà vu in all this.

It’s no secret to anyone who follows me that I’ve wondered about such dislocations and the yet-to-be-known upshot from a world awash in easy money.

When I think about all of the potential unknown dislocations from central bank actions I get, how should I say, a little really freaked out. — Old Bull Lee (@davebudge) September 15, 2015

But it’s foolish, too, to take my late-night worries and apply them to investing. As much as I’m concerned about these things, one – by that I mean I – can’t know the future. There’s plenty of Chicken Littles in the world hucking doom and gloom. If history tells us anything, the end of world is much harder to predict than its survival. After all, I’m much more deeply rooted in the thinking of Julian Simon than I am in the neo-Mathusianisms of Paul Ehrlich. You just can’t keep the human race down.

Kyle Bass echoed the BIS’s concerns this week about imbalances in EM though he was sanguine about developed markets. But he did imply that the knock-on effects probably meant slower growth for the DM world. I agree with him. You, however, must know that my agreement with Bass is ultimately little more than confirmation bias.

What conclusion can I draw from this arcane matrix of global interconnectedness? I’ll keep doing what I’m doing – looking for value. But to be clear, I do think that the market is still quite expensive. To that, intelligent people disagree and only foolish people ignore the other side of the argument. Of course I am a fool at some level. I think everyone is. I also know that admission is the first step to recovery.

Charts, charts, and more charts

Paul Tudor Jones was asked once how much of his success was attributable to technical analysis to which he responded “about half.” When asked about what part came from fundamental analysis he said “the other half.”

I’m not one to convince either the FA or TA communities that they might learn something from PJT. As I know from experience, one can’t convert the religious.

Known, as I am, for my mastery of charting I thought I’d share for your benefit – which you’d be a fool to disregard – my long term chart on interest rates.

As the lawyers say, govern yourself accordingly.

Yes, we live in interesting times and things are getting, as Alice said, “Curiouser and curiouse.”

We humans make a lot of mistakes. I suppose I say “we” as more a rationalization of my own actions than stating the obvious about mankind. Regardless, it’s true.

I had a rather “meh” week in the market. By “meh” I mean I under-performed to the tune of about 200 bps. That, however, isn’t what I consider a mistake – yet. I still have a healthy chunk of alpha YTD. Alas, there’s enough year left so that could easily change.

Reviewing Strategy

I’ve been deep into reevaluating various portfolio management strategies the last two weeks. I’m predisposed to stick to my knitting with a value strategy. Some tweaks are in order.

I recently read Quantitative Value by Gray and Carlisle which does a deep dive back-testing of Graham, Buffett and Greenblatt investment criteria. It’s another academic work that bolsters the argument that value outperforms growth over the long run. In the end they showed that a modified Greenblatt Magic Formula process delivered the highest alpha over time. And it’s no little difference either. Over a 60/40 MPT process it beats by roughly 5% annual alpha. Stick that in your compounding pipe and smoke it.

The problem for me, though, is that the age of my client base might not have the time to recover from a big draw-down. It’s a big problem. [Note: I could better exploit that model if I’d get off my fat ass and go get some younger clients.]

So that leaves me with leaning more toward Cliff Asness’ AQR model of going long value and short overpriced growth names that appear to be rolling over. As in any discipline, however, the intestinal fortitude required to practice such a process is often daunting because, as Asness says, it can be horrific at times.

And shorting stocks is a tricky game in and of itself since most of the universe (stockholders, management, employees) have an incentive to make stocks go higher. Thus, shorting is always an exercise in swimming against the natural motivation currents.

It’s been a few years since I spent real time studying Ray Dalio’s risk parity model. Given the age of my client base it might be a good solution. I recall, though, a problem for the small manager in employing the leverage needed in the fixed income allocation that Bridgewater uses to get to risk parity – especially in a low interest rate environment. I’m going to revisit it this week. Perhaps I’ll see something I didn’t see before.

Instant Classic

If you haven’t yet read Howard Marks’ latest memo, It’s Not Easy, you should. This should be required readying for everyone in the market regardless of investment style.

Opinions are like…

The never ending stream of Fed rate hike discussion seems so wrong on so many levels to me, vis a vis the marginal utility of money at the Fed Funds rate, it makes me want to scream sometimes. I’m not discounting certain effects on FX – which could be substantial – but looking at the talk of how the overnight rate affects the yield curve is mostly nonsense.

The drum beat that a rate increase will help banks is garbage unless it effects rates in the 2 – 7 part of the curve (that’s no reason to avoid banks.) There is no way to know the market reaction but my guess is that given the low inflation expectations there’s no there there.

The real effect on the curve has much more to do with Fed portfolio reinvestment than the Fed Funds rate. In that regard I have seen no evidence that the Fed has plans to let their balance sheet run off.

It doesn’t escape me that the reaction to Fed moves is really more about expectations and market psychology than it is about the efficacy of monetary policy. So in the short run I could have this very wrong. But ask yourself this, what kind of a dislocation does upward pressure on the Fed Funds rate have on the economy when the Fed has been crystal clear that policy will stay accommodative – ergo, lower for longer? Get past the initial shock and I say very little.

Of course, as I said above, we might find some players way offsides in FX leveraged carry that could cause considerable pain. I doubt that though. EM currencies have been hit hard lately. One has to ask if it’s already priced in.

But, as always, I reserve the right to be wrong.

There is another discussion that keeps popping up in my stream about the likely hood of a recession. This amuses me for a few reasons. First, only the usual suspects, who have been warning of a recession for years are making the recession argument. Secondly, the people who are arguing that no recession is on the horizon seem to outnumber the other side by about 10 to 1 (within my limited anecdotal observation.) Lastly, my 40 years of experience informs me that economic measurements are so crude and imprecise that almost no one sees recessions coming before the fact. To me this comes under the heading of things we can’t know.

For the record I don’t see a recession coming nor do I see a major expansion. So put me in the category with with everyone else – my ignorance is no better than anyone’s.

We also hear that bear markets never happen without a recession. I have to take the position that, since recessions are rarely predicted, saying so is pretty useless information other than for use in one’s bias confirmation.

Thank you for your input

I get a lot of “help” when I mention a position I have. That is to say that the world has never lacked an abundance of critics.

Just to be clear, I do a lot of homework on the stuff I trade and sometimes (often?) I’m wrong. As I’ve said, this business is hard and it’s (at least in my opinion) harder if you run other people’s money. Advisors don’t get paid to sit in cash or, if they do, their clients are over-paying (begin the “everyone’s stupid for paying management fees” here.) We take our shots where we find them with the knowledge that we will be wrong on many of them.

I was asked what my time frame this week by someone who (I think) was trying to assuage my yammering on about my under-performance. The fact is that I don’t have one but I attempt to take long term positions.

In every investment I have a thesis based on fundamentals. Regardless of short term price movements I test that theses daily – every position every day – against news, the macro background,etc. If I determine that my thesis is bunk I sell. If I determine the thesis remains, I hold or add on down prices. When price gets to what I consider to be over-extended, I sell some or all of a position. If the fundamentals improve I’ll add at a higher price. There are rules but unless one knows my theses they’re not readily seen.

I employ options if I see a fat pitch and then usually take the profits (provided I was right) and buy the common with it. And, of course, I hedge and reposition those hedges opportunistically. My options exposure rarely gets higher than 4% of my book.

I try to hold about 35 positions at any one time – which for short term traders I assume would be hard to watch.

I’m often wrong on both the downside and upside. That’s the nature of the beast.

So, I do appreciate your input. But I appreciate it more from those who have an understanding of the context of what it’s like to run money. And you’ll notice that I don’t give advise or criticize my brothers-in-arms in the advisory business. As Howard Marks said “It’s not easy.”

——–

If you made it this far I’ll consider sending refund checks. As my wife says, I could talk about a nickle for an hour if I found an audience. From now on just know that I’m issuing a standing apology.

I had a very good week. I bragged about it. Now I have the rookie jinx following me into next week.

The reality, of course, is that all the alpha I have today may turn out to be ephemeral. I did, however, also note that I under-performed last year as much as I’m over performing this year. I’m no investing genius. This business is hard.

The trouble with blowing your own horn is that, often, the braggart assigns no value to pure luck. My whole week was made on three trades which could have easily worked against me:

I carried my $SPY puts over the weekend which, after the market closed on Friday, I thought was a mistake. I carried then through Tuesday, which I also though was a mistake after the close. I took them off Wed after the tape looked like it was reversing.

I entered a limit order at the open Monday for November 14/18 $MU call spreads that filled way below my limit because some stupid traders were buying back premium they sold with market orders. That trade alone added 1.7% to my total returns for the week. I think the trade was right but I also know in a more stable market it would have contributed much less.

I put in an order for $RIG late Wednesday afternoon while it was getting pounded because, in my opinion, the market took for bad news as what I think was the best management decision the company could make. They “kitchen sinked” their balance sheet. Then oil rallied on Thursday taking up the whole sector. I’m up on the position because of that trade but that might not last. Oil could go back down. Still, I think $RIG qualifies as Peter Lynch’s definition of the best company in the most hated industry. I’m sticking with it.

When the market bounced Wed and Thursday a lot of my “high conviction stinkers” like $INTC caught a bid. Hell, almost everything caught a bid. You had to be an idiot not to be up the last two days – which I have periodically proven myself to be.

I started put my hedges back on Wednesday – perhaps a mistake – and added Thursday – which after the close yesterday I worry it might be a mistake. I do think we head back down sometime soon but I’ll take them off if we recapture roughly $SPX 2030. Which might be a mistake.

I still view this market as very expensive, contrary to some smart money managers. On the other hand, I heard Jim Cramer advise everyone in his monologue last night to ‘Buy. Buy. Buy” the FANGs which I think is delusional. I freely admit, though, it might be me who is delusional thinking value matters.

The problem with the price action of the last two weeks is that everyone piled right back into growth – from which I can only conclude that there has been no psychological correction at all. The crazy people that were the last to leave the party have organized an after-party.

Thus, I may have to wait to see the rotation into value which I know will happen. I just don’t know when. And if it takes longer than I think I likely move back into the under-performing row.

For the market’s sake I hope not. We need a good washout to start building a healthy base. At least that’s my opinion – but, as always, I reserve the right to be wrong.

The point to all of this is that it’s hard to know what part of your wins are lucky or smart. We all have a system we use. Some have harder rules than others. But when we start to think luck has nothing to do with investing we set ourselves up for failure. That’s all the more reason to have rules in our investment style.

I’m in awe of guys like Jon Boorman and Jeff Bass for their rigorous discipline. Fundamental value investing need rigorous rules too and maybe more of a stomach for volatility and it is much more art than science.

But even if you follow your rules to the letter, remember that part of investing is knowing your rules aren’t perfect. No one’s are. And luck, or lack thereof, plays a role.

If you’re not humble going in you probably will be going out. That is and has always been true.